assignment 1 week 1 the mba decision bus 650 gm dr rahul d parikh
TRANSCRIPT
The MBA Decision 1
The MBA Decision
Rahul Parikh
BUS650: Managerial Finance (MAH1209A)
Dr Charles Smith
March 4, 2012.
MBA Decision 2
The MBA Decision:
1. How does Ben’s age affect his decision to get an MBA?
Ben graduated 6 years ago, as a Finance Major, and has a goal to become an investment
banker. Ben’s age is one of the critical factors affecting his decision to get an MBA, because
of following reasons: 1) his age determines how much longer he can work. 2) Time is a
critical factor for him to retire safely at an early age. 3) Lose of opportunity of potentially
higher earnings as time passes or age increases. 4) Being away from studies for many years
can cause difficulty in getting back into the study mode, and 5) Adjustments to the rigors of
an MBA program increases with age.
Analysis: He graduated from college six years ago at an age of 22 years, and he is now 28
years old, which is the standard age to get an MBA, and it will help Ben to achieve his goal
faster in short time. Assuming that he wants to work for 40 years more, he must decide to get
his MBA as early as possible, so that within 1 or 2 years (depending on school he chooses),
he can graduate with MBA, and soon start his career of investment banker at age of 29 or 30
years, and then he can safely retire at age of 69 or 70.
Secondly Ben must evaluate the cost of completing a MBA program against the higher
earning potential after graduating. Working at East Coast Yachts only pays him $50,000/
year, with expected 3% increases per year until retirement. If he earns his MBA, he would
qualify to get job offer from $78,000 or $90,000 per year (depending on school he chooses),
with 4% increases in salary per year. So looking to this figures, the earning potential after
completing his MBA, would play an important role for his life, if he completes MBA at early
age.
Thirdly, MBA program combines high-quality core curriculum with the finance
specialization curriculum that is consistently updated to ensure real-world relevancy to today
global marketplace. In MBA program, Ben has to face the problems such as dissimilar
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subject, communication, and teamwork. So, the willingness of Ben to overcome all these
strictness, and challenges, in this age is important.
Finally, Ben was away from studies for many years, which is an additional and very difficult
point to get him back into the study mode.
2. What other, perhaps non-quantifiable factors, affect Ben’s decision to get an MBA?
In case of Ben, there can be perhaps a list of Non-quantifiable factors that can affect Ben’s
decision to get an MBA, such as:
1) Family: Whether or not he is married, and if he has any children. With a spouse and/or
children, he may be less inclined to go for an MBA (especially full-time), since his family
may be less willing to the time, and money, constraints imposed by classes. His family should
consider that increased earning potential associated with MBA can help him to take better
care of family.2) Necessity to alter his attitude and divert it towards education: Since he had a
6-year gap from university or study, this can be an important factor in his decision to go for
study. 3) Necessity of at least two years experiences in respective field of his MBA
specialization: Assuming that Ben has already worked for about six years since graduated
from college, he would be having this job experience. 5) Willingness to continue the study: If
he is eager to continue the study, he will continue the study. But if he has not willingness to
study, he could do anything else, for example having jobs that would pay more or open his
own business. 6) The value he attaches to education: Completing a higher degree or a sense
of accomplishment may positively affect his decision. On the other hand the stress of a MBA
program, the time commitment, or the intellectual challenge may be negative factors in Ben’s
decision-making process. 7) Considering the geographical diversity: He has to consider the
location of his preferred university.8) other factors such as desire to pursue an MBA, job
satisfaction, and the prestige of a job, regardless of the salary, may play role in his decision
for MBA studies.
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3. Assuming all salaries are paid at the end of each year, what is the best option for Ben
— from a strictly financial standpoint?
In order to find best option for Ben, strictly from a financial point of view, I need to compare
three options: 1) Stay at his current job at East Coast Yachts; 2) Pursue a Wilton MBA; or 3)
Pursue a Mt. Perry MBA.
The net present value (NPV) of the three options must be calculated. NPV is the present
value of future cash flows minus the present value of all costs associated in a decision (Ross,
Westerfield, Jaffe, & Jordan, 2011). In this analysis, room and board costs are irrelevant since
they will remain same irrespective of college he attends. We need to find the after-tax value
of each, as follows:
Option 1: To stay at East Coast Yachts: Ben has an annual salary of $50,000; and expected
annual salary increase of 3%; work 40 more years; has an average tax rate of 26%; and an
applicable discount rate of 6.5%. The present value of Ben’s lifetime salary is calculated by
formula for Present Value of Growing Annuity: PV = C [1-(1+g/1+r)T/ (r-g)] (Ross,
Westerfield, Jaffe, & Jordan, 2011, p.146). The average tax rate of 26% reduces Ben’s salary
to $37,000. The present value of receiving $37,000 at the end of each year for 40 years can be
calculated by using formula for Present Value of Growing Annuity, and it comes out to be
$1,057,140.49
Calculation:
Aftertax salary = $50,000(1 – .26) = $37,000
His salary will grow at 3 percent per year, so the present value of his aftertax salary is:
PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}
PV = $37,000{[1/(.065 – .03)] – [1/(.065 – .03)] × [(1 + .03)/(1 + .065)]40}
PV = $1,057,140.49
Option 2: Attending an MBA program at Ritter College of business at Wilton University:
This option can give Ben a new job after completing MBA with a starting salary of $90,000;
MBA Decision 5
a $15,000 signing bonus; an expected annual salary increase of 4%; and an average income
tax rate of 31%. Assuming Ben is planning on retiring at the same age, as if he would have
stayed at East Coast Yachts, then Ben would need to work for 38 more years. Ben’s effective
salary will be $62,100, and the present value of his lifetime salary would be $$2,483,996.20.
This salary is discounted back by two years to the present time, and it equals to
$2,190,038.31.
Calculation of Future salary:
Aftertax salary = $90,000 * (1 – .31) = $62,100
His salary will grow at 4 percent per year. We must also remember that he will now only work for 38 years, so the present value of his aftertax salary is:
PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}
PV = $62,100 * {[1/(.065 – .04)] – [1/(.065 – .04)] * [(1 + .04)/(1 + .065)]38}
PV = $2,483,996.20
Since the first salary payment will be received three years from today, so we need to discount
this for two years to find the value today, which will be:
PV = $2,483,996.20 / (1.065)2
PV = $2,190,038.31
The signing bonus of $15,000 will have an effective tax rate of 31%. The present value of the
signing bonus that Ben would receive when accepting his job after graduating from Wilton
University will be $9,125.17.
Calculation for signing bonus to be paid in 2 years:
PV of aftertax bonus paid in 2 years = $15,000 * (1 – .31) / (1.065)2 = $9,125.17
The cost of attending Wilton University, and lost opportunity costs are also relevant. The
annual cost of attending Wilton University are $65,000 in tuition; $2,500 for books and
supplies; health insurance $3,000; and additional room and board expenses of $2,000; which
MBA Decision 6
totals to $72,500 annually. Discount rate will be 6.5% (R = 6.5%); and number of years for
study will be 2 years (T = 2); so the present value of two years costs will be $140,575.12.
Calculation of the total direct costs:
PV of direct expenses = ($65,000 + 2,500 + 3,000 + 2,000) + ($65,000 + 2,500 + 3,000 + 2,000) / 1.065
PV of direct expenses = $140,575.12
Ben will miss the opportunity of earning 2 years of salary at East Coast Yachts, which is also
a relevant factor in financial decision-making in this case. The present value of the two years
in salary can be found by performing calculations for a growing annuity, and it is $68,341.82.
Calculation of the indirect costs:
It is the lost salary, so the values of the indirect costs are:
PV of indirect costs (lost salary) = $37,000 / (1.065) + $37,000 * (1 + .03) / (1 + .065)2
PV of indirect costs (lost salary) = $68,341.82
Adding the present value of Ben’s salary, and signing bonus, and then deducting the present
value of the two year costs associated with attending Wilton University, and the opportunity
cost of his foregone salary, will result in a total net present value of $1,990,246.54.
Calculation for the total value of a Wilton MBA:
Value = –$140,575.12 – 68,341.82 + 9,125.17 + 2,190,038.31 = $1,990,246.54
Option 3: is to attend an accelerated one-year program at Mount Perry College, and Ben is
expected to get a job with an annual salary of $78,000; a $12,000 signing bonus; an annual
expected salary increase of 3.5%; and have an applicable average tax rate of 29%. If Ben
plans to retire at the same age as if he would have stayed at East Coast Yacht, then he would
have to work for 39 years more.
The 29% tax rate decreases Ben’s salary to $55,380; and the present value of his lifetime
salary is $1,845,997.04. This salary is discounted back one year to the present time, so it will
come out to $1,733,330.55.
MBA Decision 7
Ben’s signing bonus of $12,000 have average 29% tax rate. The present value of Ben’s
signing bonus is $8,000 for accepting a job after graduating from Mount Perry College.
The costs of attending Mount Perry College are $75,000 in tuition costs; $3,500 for books
and supplies; $3,000 for health insurance; and $2000 in additional boarding expenses; so total
sum will be $83,500. Ben will miss out one year of salary at East Coast Yachts, and the
present value of missing this salary is $34,741.78. Ben’s total cost for attending Mount Perry
College is $1,623,088.77 (–$83,500– 34,741.78 + 8,000 + 1,733,330.55).
Complete calculation:
The direct costs will occur today, and includes tuition, books and supplies, health insurance,
and the room and board expenses. So the total direct costs are:
Total direct costs = $75,000 + 3,500 + 3,000 + 2,000 = $83,500.
[Note, this is also the PV of the direct costs since they are all paid today.]
The indirect costs are the lost salary, so the values of the indirect costs are:
PV of indirect costs (lost salary) = $37,000 / (1.065) = $34,741.78
The financial benefits are the bonus to be paid in 1 year and the future salary.
Bonus to be paid in 1 year:
PV of aftertax bonus paid in 1 year = $12,000 * (1 – .29) / 1.065 = $8,000
Future salary:
His aftertax salary at his new job will be:
Aftertax salary = $78,000 * (1 – .29) = $55,380
His salary will grow at 3.5 percent per year. We must also remember that he will now only
work for 39 years, so the present value of his aftertax salary is:
PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}
PV = $55,380 * {[1/(.065 – .035)] – [1/(.065 – .035)] * [(1 + .035)/(1 + .065)]39}
PV = $1,845,997.04
MBA Decision 8
Since the first salary payment will be received one year from today, so we need to discount
this for one year, to find the value today, which will be:
PV = $1,845,997.04 / 1.065
PV = $1,733,330.55
So, the total value of a Mount Perry MBA is:
Value = –$83,500– 34,741.78 + 8,000 + 1,733,330.55 = $1,623,088.77
Attending Mount Perry College will result in a net present value of $1,623,088.77.
Conclusion: From a strict financial standpoint, Ben should attend Wilton University, because
this option has the highest net present value.
4. In choosing between the two schools, Ben believes that the appropriate analysis is to
calculate the future value of each option. How would you evaluate this statement?
Ben is somewhat correct. Calculating the future value of each option will result in an option
with the highest present value, having the highest future value. Thus, a future value analysis
will result in the same decision. But, his statement that a future value analysis is the correct
method is wrong, because net present value analysis will give the correct answer as well.
5. What initial salary would Ben need to receive to make him indifferent between
attending Wilton University and staying in his current position? Assume his tax rate
after graduating from Wilton University will be 31 percent regardless of his income
level.
To be indifferent between attending Wilton University, and staying in his current position,
Ben needs to have a starting salary after graduating that will result in the same net present
value, as his lifetime salary of staying in his current position minus all costs. This means that
the present value of the signing bonus, and all the costs, must be added to the present value of
the lifetime salary that Ben would earn at East Coast Yachts, and it is $1,256,932.26
($1,057,140.49 + 140,575.12 + 68,341.82 – 9,125.17).
MBA Decision 9
Since Ben would start his job in two years, this present value must then be converted into a
future value. The future value of $1,256,932.26 using a discount rate of 6.5% is
$1,425,644.00. Assuming an expected annual salary growth of 4%; and using a calculator to
determine the payment amount of a growing annuity, the initial annual salary must be
$59,950.53 after taxes, and by multiplying it by 1.31 results in an annual pre-tax salary of
$86,884.83. This means if Ben would have a starting salary of $86,884.83 after completing
his MBA at Wilton University, he would be indifferent about his decision. If he would earn
more than $86,884.83, than it would be in favor of earning his degree at the university, but if
he earns less, he should decide against the MBA program at Wilton University.
Calculation:
PV = $1,057,140.49 + 140,575.12 + 68,341.82 – 9,125.17 = $1,256,932.26
This PV will make his current job exactly equal to the Wilton MBA on a financial basis.
Since the salary will not start for 3 years, we need to find the value in 2 years so that it is the
present value of growing annuity, so:
Value in 2 years = $1,256,932.26 * (1.065)2 = $1,425,644.00
Since his salary will still be a growing annuity, the aftertax salary needed is:
PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}
$1,425,644.00 = C {[1/(.065 – .04)] – [1/(.065 – .04)] × [(1 + .04)/(1 + .065)]38}
C = $59,950.53
This is the aftertax salary. So, the pretax salary must be:
Pretax salary = $59,950.53 / (1 – .31) = $86,884.83
6. Suppose that instead of being able to pay cash for his MBA, Ben must borrow the
money. The current borrowing rate is 5.4 percent. How would this affect his decision to
get an MBA?
MBA Decision 10
The cost (interest rate) of the decision depends on the riskiness of the use of funds, not the
source of the funds, means taking a loan increases the risk, and the costs, of pursuing a MBA.
If Ben is not able to find a job after graduating, he will have the loan amount, and interest
expense, to pay off. The borrowing rate of 5.4 also increases his overall costs of getting a
MBA. Once Ben knows the exact loan terms, he could calculate the present values of all
interest expenses, and include them in his net present value assessment of the various options.
In fact, whether he can pay cash or must borrow is irrelevant, so I advice that without adding
loan expense to the total coast, and thereby increase risk of using his funds, he should use his
savings, to go to Wilton University to pursue his MBA.
MBA Decision 11
References:
Ross, S., & Westerfield, R., Jaffe, J., & Jordan, B. (2011), Corporate finance: Core
principles and applications (3rd Global ed). Boston, MD: McGraw-Hill Irwin. ISBN:
978-0-07-353068-0.